Review of Empirical Literature on Audit Quality and Cost ...ijatnet.com/journals/ijat/Vol_2_No_4_December_2014/5.pdf · 82 International Journal of Accounting and Taxation, Vol. 2(4),

International Journal of Accounting and Taxation December 2014, Vol. 2, No. 4, pp. 81-92

ISSN: 2372-4978 (Print), 2372-4986 (Online) Copyright © The Author(s). 2014. All Rights Reserved.

Published by American Research Institute for Policy Development DOI: 10.15640/ijat.v2n4a5

URL: http://dx.doi.org/10.15640/ijat.v2n4a5

Review of Empirical Literature on Audit Quality and Cost of Debt Capital

Alireza Eskandari1 Assoc. Prof. Dr.Siti Zaleha Abdul Rasid2 Dr. Rohaida

Basiruddin3 & Mohammad Reza Hosseini4

Abstract

This paper reviews empirical studies over the past decades in order to assess what researchers have done about the impact of audit quality on the cost of debt capital. Audit quality encompasses of an external mechanism intended to mitigate information asymmetry by increasing the monitoring of management’s actions, limiting managers’ opportunistic behavior, and improving the quality of firms’ information flows.A stream of literature explains that audit quality of external auditor mechanisms such as auditor size, audit fees, non-audit services and auditor industry specialization are able to contribute towards improving the firm’s performance and reducing information asymmetry. The other dimension of value creation is the reduction in the cost of debt capital raised by firms. Theoretically and empirically to some extent, high audit quality of external auditors will lead to lower firm risk, information asymmetry and subsequently, a lower cost of debt capital. This paper aims to provide a critical review of the empirical literature on the effect of audit quality on the cost of debt capital.

Keywords: Audit Quality, Cost of Debt Capital and Information Asymmetry

1. Introduction

Audit is a key contributor to financial stability and to re-establish trust and

market confidence. Auditors are entrusted by law with conducting statutory audits

and fulfill an important role in offering an opinion on whether the financial

statements are stated truly and fairly (Quick, 2012). This assurance should reduce the

risk of misstatement, subsequently, reduce the costs of business failures.

1Phd candidate of International Business School (IBS),UniversitiTeknologi Malaysia (UTM), 54100 Kuala Lumpur, Malaysia. Phone: +60173055092, Email: [email protected] 2International Business School (IBS), UniversitiTeknologi Malaysia (UTM) 3International Business School (IBS), UniversitiTeknologi Malaysia (UTM) 4Malaysia – Japan International Institute of Technology (MJIIT),UniversitiTeknologi Malaysia (UTM)

82 International Journal of Accounting and Taxation, Vol. 2(4), December 2014

The external audit exercise is a governance procedure that reviews and

analyses a company's internal audits and control the fiscal reports to avoid material

misstatements. According to Wallace (1980), claims that shareholders demand audited

fiscal reports as these reports offer details that are beneficial for their decisions on

investments; hence, the external audit would act as a tracking device that decreases

managers’ interests in misstating the earnings. Thus, the audit is used as a method of

enhancing the top quality of the fiscal information; hence, it is expected that a better

audit quality will be linked with reduced cost of capital by companies. Shareholders

depend on the external auditor to offer some guarantee that the fiscal reports of a

company are not deceiving. It is critical that the tracking mechanism offered by the

external auditors is not affected and becomes the most essential aspect for the proper

delivery of an independent auditing function.

The value of auditing is both internal and external. To the auditee, defined as

the organization to be audited, audit assurance is supposed to decrease the risk of

internal controls, misstatement and hence, decrease the possibility of business failure.

Forthe information users outside the organization, the assurance will reduce the risk

of information asymmetry; optimize the allocation of resources, thus, improving the

efficiency of capital markets.

The accounting role has to face a growing pressure from external elements to

observe and enhance the high audit process of company (Sutton, 1993). To contend

efficiently in this setting, audit companies must continuously endeavor to enhance the

audit quality and increase customer satisfaction. Firstly, the auditor’s capability is to

analyse the records and recognize mistakes or flaws, i.e. their technical proficiency,

and secondly, their objectivity or detachment, i.e. their independence.The auditing

quality is the unique blend of the auditor’s ability to recognize and report issues found

in the records (R. Watts & Zimmerman, 1986). According toDeAngelo(1981),

defining audit quality is beneficial for research as proficiency and independence to

carry out their jobs are quite unique constructs. Nevertheless, these two

measurements are not very different nor separate: for instance, the audit company

could determine not trying to locate the problematic areas (competence) which they

do not wish to report (independence).

Technical proficiency is comparatively simple to contemplate. Nevertheless,

independence is more difficult in proving and simpler to go against (Mednick, 1990).

Eskandari et al. 83

According toDuff (2004), audit quality consists of technical and service quality

(the degree of customers’ satisfaction and meeting their requirements). Technical

quality involves capability, reputation capital, expertise, scales of independence and

experience, while quality of service is defined by empathy responsiveness, and the

supply of client services andnon-audit services.

The agency theory suggests that the principals’ interests and the agents may

not be the same and that tracking of the management is a technique of decreasing

agency cost (M. C. Jensen & Meckling, 1976). Information systems on corporate

governance is used for monitoring (Eisenhardt, 1989); one such tool being the

external audit (R. L. Watts & Zimmerman, 1983). The stakeholders and managers

have rewards for motivating such (Fama & Jensen, 1983a, 1983b).

One of the key elements that affect the reliability of fiscal reports are said to

be the audit quality (Arruñada, 2004). The stakeholders would show more confidence

on the information revealed in the fiscal reports if the audit of the fiscal reports is

recognized to be of top great quality. The auditing quality is based on the likelihood of

the auditor being able to find and report any misappropriation in the financial reports

(R. Watts & Zimmerman, 1986). DeAngelo (1981)study on the audit quality pointed

out two important aspects that it is dependent on.

In considering the cost of capital, this review of empirical literature focuses on

the public debt market for several reasons. First, Modigliani and Miller (1958, 1963)

show that managers seek to maximize shareholder wealth to invest in positive net

present value projects by minimizing the cost of financing. Debt financing is generally

preferable when the tax shield and the leverage effect are to the debtor’s advantage.

Mackie‐Mason (1990) and Ely et al. (2002) show that firms with higher marginal tax

rates prefer debt since they can enjoy the interest tax shield. Scholes et al. (1992) and

Carter and Manzon Jr (1995) find that firms that cannot make efficient use of tax

shields prefer to issue a security that is tax-favoured in the hands of the

holder.Secondly, the public debt market is a significantly larger market than the equity

market. The Federal Reserve System’s flow of funds data shows that over the past

decade, there have been $780 billion in net debt security issuances but only $2 billion

of equity issuances(Graham et al.,(2008).Third, compared to the pricing of equity,

which might be affected by the misspecification of the equilibrium pricing model,

bond pricing is relatively well defined (Mansi, Maxwell, & Miller, 2004).


The information asymmetry not only exists in the equity capital market, but

also causes big problems in debt capital markets. That explains the reason why

researchers continue searching for relations between information quality and cost of

debt capital to find a way to reduce interest expense for companies. Audit contributes

to investor protection (Newman, Patterson, & Smith, 2005), reduces perceived

investment risk and thus, cost of capital. Theory posits that an audit by an

independent party reduces the information asymmetries; subsequently, reduce the

possibility of moral hazard and adverse selection problem between information

providers and information users.

The objective of this paper is to review the limited but expanding body of

literature on the effect of audit quality on the cost of debt capital. The remaining of

this paper is organized as follows. The next section looks at the measurement of audit

quality and empirical evidence of audit quality on the cost of debt capital. The final

section concludes this paper and provides suggestions for future research.

2. Measuring Audit Quality

It is challenging and complicated to measure audit quality (K. L. Jensen &

Payne, 2005; Niemi, 2004; Wooten, 2003). Nevertheless, according to Bailey and

Grambling (2005),Francis (2004) and PCAOB (2008); there are several possible

measurements of audit quality available in practice and in the literature. This set of

researches includes two parts. The first group of researches using direct measures like:

financial reporting compliance with GAAP, bankruptcy, quality control review, desk

review and SEC performance are used as a measure of audit quality (Chadegani,

2011). In the second studies, indirect measureslike: auditor tenure, industry expertise,

audit fees, economic dependence, audit size, reputation and cost of capital are used as

a measure for audit quality (Chadegani, 2011). The impact of indirect measures of

audit quality will be reviewed in this study on the cost of debt capital and they will be

reviewedin detail in the following sections

.

3. Literaturereviews of Audit Quality and cost of Debt Capital

From a theoretical viewpoint, empirical investigation proposes that low audit

quality will lead to amplified information asymmetry, which may increase the

uncertainty of investment or future cash flows.

Eskandari et al. 85

Summing up the prior empirical studies, audit quality has been found to have

a linkage with the cost of debt capital, with higher audit quality leads to a lower cost

of debt capital. The following section reviews the findings of prior research with

regard to the relationship between audit quality and cost of debt capital. Compare to

the mentioned proxies for audit quality; the size, auditor choice, reputation, brand

name, audit fees and industrial-expertise of audit firms have influences on audit

quality. Especially, the two-tier auditing industry provides chances to analyze the

differences between the services provided by Big N and non-Big N firms.

3.1 Auditor Industry Specialization

Prior research documents that auditor industry specialization enhances

financial reporting quality and mitigates fraudulent financial reporting (Carcello &

Nagy, 2004; Krishnan, Sami, & Zhang, 2005). Lou and Vasvari(2009) examined

whether companies’ selection of an audit specialist could reduce the cost of debt faced

when having access to the public debt market. They used bond issues in the U.S. as a

large sample for their study. It was found that bond investors and credit agencies

appreciate the benefits of industry audit specialists. Companies that engage industry

audit specialists get higher credit ratings and offer prominently reduced yields when

bond securities are issued. Chu et al (2009) findings show that depending on the

likelihood of bankruptcy, banks depend on various monitoring tools. For companies

with a lesser likelihood of bankruptcy, banks are not dependent on the corporate

governance quality or the auditor’s specialization of an industry. Nevertheless, the

auditor’s tenure and a shift of the auditor have an effect on the spread. For companies

with a high chance of bankruptcy, the spread is moved to view the corporate

governance quality and the specialization of the auditor. These findings are contingent

on alternative measures and specifications.

Li et al (2010) investigated the link between specialist auditors in the industry

and the cost of debt financing by utilizing a city and national level industry specialist

guideline. In line with the assumption that higher audit quality is linked to a reduced

information risk, which is good for clients in getting debt capital, it was found that

companies audited by the auditors from the city level industry specialist, either jointly

or individually with auditors from the national level industry specialist, experienced a

major reduction in the cost of debt financing as calculated by bond spread and credit

rating.


Furthermore, the findings revealed that for joint city and national level

industry specialists, both insurance and information functions are important in

lowering the cost of debt financing.

In a study by Wahyuni(2013), the data used are 789 firms of observation years

during 2000-2010 in Indonesia. From this amount, 291 samples are high profile

industry. Consistent with expectation, the results of this study find that (1) auditor

specializations are factored into the firm’s bond rating by credit rating agencies; (2)

auditor specialization is negatively and significantly related to the cost of debt

financing; (3) the relation between auditor specialization and the cost of debt

financing is most pronounced in a high profile industry. Overall, their result suggests

that auditor specialization matters to bond market investor in Indonesia.

3.2 Audit Fees and Non-Audit Services

Most of the literature on auditor independence focused on the external

auditor’s provision of non-audit services. Another issue emphasized in this study is

whether the provision of non-audit fees and audit fees as measures of auditor

independence and audit quality influences the cost of debt capital.

A study conducted by Dhaliwal et al. (2008) investigated the link between the

fees of auditors and the cost of debt, and the impact of the fees on the association

between information on the financial statements and the cost of debt. It was found

that non-audit fees are related directly to the cost of debt for issuers of investment

grade. The findings are dynamic in controlling the tenure of the auditor and corporate

governance, and evidence was found that the relation between earnings and the cost

of debt declined as audit fees went up. No evidence was found that auditor fees have

a direct effect on the cost of debt for the noninvestment-grade companies, but it was

discovered that the relation between earnings and the cost of debt declined as non-

audit fees went up.

3.3 Auditor Size and Reputation

The study of Fortin and Pittman (2004) investigated the effect of auditor

selection on debt pricing in companies’ early years of going public when they

specifically depend on getting external financing in spite of facing serious information

issues.

Eskandari et al. 87

The cross-sectional study claimed to have a Big Six auditor, could decrease

debt-related monitoring expenses by improving the credibility of financial reports,

which allows young companies to reduce their borrowing expenses. Karjalainen(2008)

studied the link between the choice of auditor and the cost of debt financing for small

and medium-sized private enterprises (SMEs). Time series of cross-sectional data of

832 private and limited SMEs in Finland was used. The findings showed that the

selection of an internationally famous audit company is negatively related to the

predicted cost of debt financing for SMEs.

Research of Lai (2011)revealed that interest charge is related positively to

investment opportunities for all-equity companies. This link is weaker when the

companies hire the Big 4 auditors or have a higher share of debt chargeable in the

following year over the whole debt. Furthermore, the findings above are not

applicable for highly leveraged companies as the lenders are always monitoring their

borrowers’ financial condition.

.

3.4 Different Approach ofAudit Quality and Cost of Debt

Previous studies on the link between audit quality and cost of debt have been

investigated from various approaches namely voluntary audits, auditor’s choice,

audited SMEs firms and younger technology companies and older non-technology

companies. Hwang et al. (2008) investigated the link between switching auditors and

the response of the bond market among listed companies in Korea. They examined

the direct link between switching auditors and the response of the bond market, as

well as the impact of switching auditors on the response of the bond market to the

quality of earnings. The findings show that external investors both respond to the

switching of auditors and also take into consideration the switching behavior when

assessing the quality of earnings. The growth in impacts is prominent for companies

whose audit quality has improved, which relates to the fact that the investors’ concern

regarding switching of auditors reduces when switching of auditor causes an

improvement in the auditing quality.

Kim et al. (2011) studied private Korean firms as their sample for a duration

of 16 years from 1987 to 2002 including 1997 which was the year of the Asian

financial crisis.


It was found that private firms that had carried out voluntary audits paid

comparatively reduced interest rates for their debt compared to private firms that had

not carried out audits. It was revealed that the hiring of Big 4 auditors does not cause

more decrease in the interest cost of borrowing, in comparison with the hiring of

non–Big 4 auditors.

Causholli and Knechel(2012) investigated the setting where a high audit

quality lowers a company’s cost of debt. It was discovered that young companies at

the IPO time paid higher interest rates and auditor quality played a huge difference in

reducing the financing’s cost of debt. In line with the hypothesis that was proposed,

the researchers also found that the impact of auditor quality is bigger for companies in

the high technology industry sector. Additionally, the link between auditor quality and

age was reliant upon the industry, with the advantages of employing auditors of high

quality mainly accrued to younger technology companies and older non-technology

companies.

Huguet and Gandía(2012) investigated the link between the costs of debt

capital and auditing within the SME framework, a subject not studied much in

previous literature and that yielded contradictory results. They used Spanish SMEs as

the sample for the study, which contained audited firms, with voluntary and

mandatory audits, and non-audited firms. It was discovered that auditing assisted in

lowering the cost of debt for SMEs, but only for firms that were more than a

particular size. In addition, it was discovered that for bigger SMEs, the auditing had a

lesser effect on the cost of debt as the size increased. SMEs audited by the Big 4

auditors were not found to have a reduced cost of debt compared to those audited by

non-Big 4 auditors.

Using a sample of 823 firms from 35 countries, Ben-Nasr et al. (2014)

examined the impact of auditor’s choice on bond ratings. They find strong evidence

that the auditor’s choice significantly affects the bond ratings. The model also shows

that the quality of legal and extra-legal institutions plays an important role in

improving debt ratings. More specifically, they find that the existence and the

enforcement of creditor laws are associated with higher bond rating.

Only in recent years that researchers have begun to investigate the impact of

audit quality of external auditor’s mechanisms on the other dimension of firms’ value

that is the cost of debt capital.

Eskandari et al. 89

It can be argued that if firms are able to enjoy a cheaper cost of raising capital,

a value has been created for shareholders. Based on the limited but growing literatures

on the relationship between audit quality and the cost of debt capital, stronger

external CG mechanisms such as audit quality of external auditor are able to mitigate

information asymmetry and the agency problemthat highlights the capital markets. In

an agency relationship in which information asymmetry problems arise, the suppliers

of financial statements are assumed to be dishonest in reporting financial information.

As such, the users of financial statements are incapable of distinguishing between

honest and dishonest information. In this situation, the demand for independent

audits can be seen to result in the financial statement of users receiving honest reports

(Wallace, 1980). Thus, audit services inform the market that the financial statements

provided by the management are also free from material errors.Prior studies had

utilized audit quality measurement variables such as auditor size, audit fees, non-audit

services, auditor industry specialization, and remuneration in this strand of research.

4. Conclusion and Future Studies

Theoretically and empirically to some extent, high audit quality of external

auditors will lead to lower firm risk and subsequently to a lower cost of debt capital.

Firms that are well-managed in terms of the existence of internal and external robust

monitoring devices as well as the provision of quality financial reporting and

protection of stakeholders’ well-being, will be able to limit the exercise of power of

corporate managers and carefully allocate resources, which in turn enjoy lower risk

than other firms.It follows that these firms should have access to cheaper source of

capital, either in the form of equity or debt or both, than other firms. A few areas can

be the focus of future research.First, the impact of audit quality on the cost of debt

capital in emerging markets such as the East Asia, Eastern Europe and Russia should

be undertaken so as to enable generalization of research findings. Lastly, future

research could also draw on cross-countries comparisons by examining the influence

of different level of accounting principles and their level of implementation on the

cost of debt capital.


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